For every small business owner who wants to get on Shark Tank, sell their business, or one day retire, knowing how to value a business is invaluable for your company’s future.
Your business value represents your company’s worth in every way possible. When you’re offering shares, seeking partnerships, and applying for loans, investors, financiers, and more may consider this number to determine how great the opportunity you’re presenting really is. It’s a piece of knowledge that you should be prepared to offer in situations you may not even expect, which we’ll go over in this article.
Keep reading to learn everything you need to know about business valuation and how it’s done, so you can move further on your path to becoming a successful entrepreneur.
What Is Business Valuation?
Business valuation is the process that helps you calculate exactly how much your company is worth. The process will take into account your business assets, salary, industry, and much more.
By tacking a dollar amount onto your business, you’ll be able to set goals and accurately analyze your annual growth. Plus, your business value will prove critical in a wide variety of situations that affect large and small business owners alike. These include situations where you’re:
- Selling to potential buyers or buyout firms
- Merging with another company
- Seeking investors for your business
- Retiring from the company
- Bringing a new owner, partner, or other shareholder on board
- Recruiting high-level employees
All of these situations typically lead to new stakeholders, who will naturally want to understand the value of the business before getting involved. This allows them to understand if your offer is fair and worth their time, or if they should seek opportunities elsewhere.
From a more personal angle, the value of your business will also be necessary in determining divorce settlements, taxation, and inheritance.
How to Value a Business
Your business’s worth can be determined in many different ways, but most experts use three common business valuation methods that are trusted to provide accurate results. Each of these valuation methods will take into account different aspects of your company.
We highly recommend that you allow a qualified employee, contractor, or other third-party entity to complete your company valuation. By hiring an outsider, you increase objectivity and get a clear view of your business as a whole. This person may be a business adviser or accountant, though business brokers and real estate agents may also be able to help you. Some experts may be specifically certified to assess business values.
That said, we don’t need to get into the specific mathematics of completing your business valuation. Instead, we’ll dive into an overview of the three methods, so you know what business valuation method is best for you. While reading this section, you’ll also learn what financial indicators you should track to help the process go smoothly.
The asset-based valuation method takes into account your assets and your liabilities to produce a final business value. There are two main approaches to this method:
- Going concern approach: If your business will continue to exist beyond the valuation process, this approach is ideal. This will subtract your liabilities, which includes business loans and accounts payables, from your net asset value. Your net asset value should include the worth of both tangible assets (like cash and equipment) and intangible assets (like intellectual property and your customer base).
- Liquidation approach: If your business will close in the near future, this approach will offer the most realistic valuation for you. The final value you’ll be left with will be the cash you can expect to receive after assets are sold off and liabilities are paid in full.
As you may see, the first asset-based approach is best reserved for companies that are expecting to continue or grow, while the second is ideal for companies that aren’t turning a profit. Because of this, the asset valuation method will always provide the lowest final business value out of all the methods, though your going concern value will always be higher than your liquidation value. This is because the liquidation approach operates under the assumption that your assets will be sold off in a fire sale, which drastically lowers prices due to the urgency.
Still, companies with a lot of assets or liabilities to take into consideration can benefit from this approach, even if they are in a healthy state. On the other hand, it isn’t recommended for sole proprietors, who will have a hard time separating personal and business assets. This method is more appropriate for limited liability companies.
This income-based method, as you probably expect, uses business income to calculate the total value of a business. The exact approach you use will depend on what stage your company is at.
If you own a startup or new business that you expect to turn a high profit — no current profit needed — we recommend using the “discounted cash flow” approach. This approach will tell you your company’s value based on your projected future cash flow, minus a discount rate. The discount rate decreases the present value of your future earnings to account for inflation. This allows the business valuation to stay accurate over a period of time.
If your small business is in a good spot — with a positive net income and a history of earnings to work with — you can use the “capitalization of earnings” approach. This approach will look at the data you already have, taking out any big outliers, to predict your future profits.
With the income-based valuation method, you may be asked to calculate your seller’s discretionary earnings (SDE). SDE will take into account one-time costs, how much you earn, and more. This will produce a highly accurate business value that greatly helps you and your stakeholders when making decisions.
Finally, a market-based valuation will base the value of the company on how your business’s net profit compares to the current market. For the most part, your final business value will be based on recent sales and market values of similar businesses in your industry. The person performing your business valuation will then be able to adjust for your growth potential, when considering the goods and services you provide and how many competitors you have.
This is an approach that works for every type of company, which is why it’s favored by many business owners. In the end, you’ll have a fair market price, which is especially helpful if you want to exit your company.
Frequently Asked Questions
Now that you have the basics of business valuation down, you may have some questions left. Here, we’ve answered three common questions that business owners have about their company’s value.
1. Can I value my business if I hold a franchise, rather than my own company?
Yes, a business valuation is still possible using any of the methods listed above. However, if you’re selling your business, we do recommend looking at your franchise contract before hiring a professional to do your business valuation work. This is because some franchise businesses may have a stated value that your business must be sold for, or that the parent company will purchase the business back for.
2. Would I ever need to use multiple methods to determine my business value?
In some cases, your hired expert will suggest using multiple methods to get the most accurate value possible. However, for some businesses, a single method will be all that’s needed to get a fully accurate business value. Consulting with an expert will help you narrow down the best approach or blend of approaches for your situation.
3. How often do I need to get a business valuation done?
Most small business owners can get away with getting a business valuation once per year. We recommend no less because your business value will typically no longer be valid after this time frame. However, if you are consistently seeking loans and investors or your company is expanding quickly, it may be worth it to get your business valuation done quarterly. You’ll also want to have a business valuation done immediately if you’re planning to retire, sell, or liquidate.
Be Prepared for Every Business Situation
Understanding how to value a business is non-negotiable as a business owner. While you may be able to hire out the actual work, you still need to know what numbers and information you need to pull before valuing your business. Plus, not looking silly in front of potential partners, investors, and buyers depends on your ability to explain and defend your business value.
Looking for a business calculation you can do yourself? Read this article to learn how to calculate your profit margin in a matter of minutes.